How is the Cost of Life Insurance Determined?

Published In Insurance

March 28th, 2016

Before we get into a full discussion of the cost or price of life insurance, let’s identify and correctly define some terms.

  • “Cost” and “price” are not accurate terms to describe the amount paid to an insurance company for life insurance or for any other kind of insurance. The correct word is “premium.”
  • A “rate” is an amount of money per unit of risk exposure. In property insurance, the unit of risk exposure is usually $100 worth of property value. In liability insurance, like the liability coverage of an automobile policy, the unit of risk exposure is usually $1,000. Therefore, the premium for these kinds of insurance is broadly determined by multiplying the amount of insurance times the rate.
  • “Risk factors” are the elements that go into the determination of rates. For the most part, they are variables specific to the person, entity, or thing to be insured. For example, for the structure coverage of a homeowners insurance policy, a risk factor would be whether a house was built of wood or brick. For the liability coverage of an automobile policy, a risk factor would be the number of miles driven per year.

The Basic Calculation of Life Insurance Premiums

The “rates” for life insurance are generally easier to understand and determine than that for other kinds of insurance. That’s because life insurance premiums are based mainly upon mortality. In the context of insurance, mortality refers to the rate of death of a specific population. Mortality tables, which are compilations of death rates of vast numbers of people and reflect the number of deaths at various ages, are used by life insurance companies to determine premiums.

Age is the main factor in mortality tables, but there are others. Some of the others are gender, smoking and pre-existing health conditions of various types. Unlike health insurance, pre-existing health conditions are allowed to be considered by life insurers in accepting or denying applications and in the terms upon which life insurance policies are issued.

Based on the historical death rate of a group of people of a stated age who, for example, do not smoke, a life insurance company can project the average age of death of a member of that group. A similar projection can be made of a group who do smoke, who have a history of an illness, or a group of people of a different age.

Let’s look at a simple example. We’ll use term life insurance so we do not have to account for the added complexity of cash value. Suppose that 1000 50-year-old men want to buy $1,000 of term life insurance. Suppose further that they don’t smoke. A mortality table may show that 3.32 of the group may die before reaching 51. Therefore, a life insurer insuring the group would have to pay $3,320 in death claims. To do so, the life insurance company has to collect at least $3.32 each year to pay the expected death claims. As a practical matter, it would have to collect somewhat more than that to pay administrative costs and realize a profit.

Another factor that enters into the determination of life insurance premiums (and all other insurance premiums) is that the insurance industry is a highly regulated one. State insurance regulators are concerned with many aspects of insurer operation, but a primary one is solvency. Solvency refers to the ability of an insurer to pay expected claims as presented. Therefore, State insurance regulators impose requirements, including those requiring insurers to maintain statutory reserves. These are intended to ensure that that there is enough money on hand to pay anticipated claims.

Specific Life Insurance Premium Considerations for Seniors

Over 50: When you were under 50, the main goal of life insurance was probably income replacement. But past 50, you may be considering it more as a part of overall financial planning, and health, and the remaining length of your life; may be factors. Therefore, if you buy life insurance, the kind that you buy, when you buy it, or if you keep what you have depend on your individual needs and your ability to pay the premium. You may still have children to support or to educate, a spouse to provide for, and a mortgage to pay, making life insurance worthwhile. It requires careful examination and professional guidance to determine whether the cost of maintaining life insurance at this stage of your life outweighs, or is outweighed by, other financial needs.

Over 60: If income replacement remains a factor, existing term policies bought while you were younger may still be in force. Even if they are not, term policies may still be available. Be prepared for higher premiums due to age or intervening medical conditions.

If your financial circumstances are more complex, such as funding an estate, permanent life insurance may be desirable. Although it is more costly, cash value accumulates in simple permanent policies. There are also variants, such as universal life policies that allow greater flexibility.

Remember always that life insurance is meant for protection; it is not an investment. Nonetheless, with guidance from a skilled financial professional, it can be a valuable part of a Senior’s overall financial plan.

For more information read: What is Life Insurance and Should Older Adults Buy It?

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